Here’s how anxiety over the U.S. debt ceiling may play out in markets

Investors continued to pour money into the Treasury market’s shortest-dated security on Friday amid ongoing worry over the U.S. debt ceiling and the possibility that the government might default on its debts.

Those worries came to the fore this week as investors sought out the safest place to hide: the 1-month Treasury bill

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Enormous demand for the bill sent its yield into a steep dive on Thursday, falling by more than half a percentage point at one point to 3.215% before paring the drop, according to Tradeweb. On Friday, the rate settled at 3.348% as of 3 p.m. Eastern time — down 18.3 basis points from Thursday’s close of 3.531%, and its lowest level since mid-October, according to Tradeweb.

Volatility similar to what was seen this week is likely to keep playing out in the near term as investors avoid bills maturing in July and August, according to strategists at TD Securities. That’s the time that TD strategists say the so-called X-date is likely to be — or period after which the Treasury may not be able to pay all of the U.S. government’s bills.
 
“In the last week or so, 1-month bills have really started to richen, largely as investors try to avoid debt-ceiling issues and due to uncertainty about the outlook for equities and interest rates,” said Gennadiy Goldberg, a senior U.S. rates strategist at TD. “A lot of investors are hiding out in very liquid 1-month bills, but paying a high price to do so because the rate is lower than on other bills” in the Treasury market.  

 “It’s not just money-market funds doing it, but a number of other investors such as asset managers, who do not typically invest in the 1-month T-bill space and are keeping a significant amount of dry powder on hand,” Goldberg, based in New York, said via phone on Friday. “The closer we get to the debt-ceiling X-date, the more extreme the bills dislocation will become: bills impacted by the X-date will probably be cheaper as investors look to avoid them. Right now, equity investors are more focused on earnings and the economic backdrop, but may start to get nervous as we approach the X-date without a solution.”  

Read: Fears of a Default Spur Buying Frenzy of 1-Month Treasuries

On Friday, Treasury yields — except for the 1-month T-bill rate — finished higher in New York trading as investors sold off most government debt and piled into the shortest-dated security. Meanwhile, all three major U.S. stock indexes

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eked out slight gains for the day, but ended modestly lower this week after the first batch of earnings reports disappointed investors.

Behind this week’s anxiety in the T-bill space is the fact that federal tax receipts have come in weaker than expected, raising concern that the government could run out of money in a matter of months unless Congress raises the $31.4 trillion debt ceiling, which was reached in January, prompting Treasury to take extraordinary measures. On Friday, the cost of insuring exposure to U.S. sovereign debt reportedly rose to the highest level since 2011.

On Wednesday, House Republicans unveiled a plan that would cut government spending in exchange for a higher limit on government borrowing. By contrast, the White House and congressional Democrats have called for an increase in the ceiling without conditions.

Since debt-ceiling negotiations may be the most contentious since 2011, TD strategists said they see a chance that the use of the Federal Reserve’s overnight Reverse Repo (or RRP) facility could grow in the near term. The facility is largely used by money-market funds, and its usage has swelled as the result of Treasury’s decision to cut the supply of bills and the stress in the regional bank sector in March. Balances in the facility have soared to $2.3 trillion.

Cash that might otherwise be going to T-bills maturing beyond one month might be pulled out of the system too quickly, resulting in a reserve-scarcity episode similar to the one seen in September 2019, Goldberg said. That “could create ripples in the financial system if we get too close to the debt ceiling without a resolution,” he said.